| wealth management  by Brad M. Weafer, CFA, Chief Investment Officer

December has arrived, and the holidays are rapidly approaching. My children have already submitted their wish lists for holiday gifts and it is time we do the same. As we do annually, we will consider this past year and compile our own list of the things we hope 2019 provides.

2018 in Review

2018 has been a roller coaster year for U.S. equity investors. With a landmark change in both the individual and corporate tax code, the S&P 500 started the new year much like it finished 2017, strong. Through January 26, the index quickly gained 7.5%. That all changed in a blink. Investors were shaken out of their complacency by an 8.7% decline over the following two weeks, wiping out the year-to-date gains. Not a major correction, but the largest draw-down the U.S. experienced in over a year. 

While stocks reeled in February, the outlook for the U.S. economy and corporate profits continued to be attractive. With an assist from expansionary fiscal policy, GDP growth accelerated to 4.2% in the second quarter and 3.5% in the third quarter. Not surprisingly, the boost in the economy helped drive solid revenue growth for S&P 500 companies (over 9% in Q2 and Q3). Pre-tax profit margins expanded to record highs. Coupled with a drop in the U.S. corporate tax rate from 35% to 20%, S&P 500 earnings per share grew 25% over the last two quarters. Stocks followed these robust earnings results to all-time highs in September. 

With earnings and the economy on solid footing, it would seem only policy errors could derail the market in the short-term. Sure enough, concerns in this area bubbled to the surface in late September. Fears of both a fiscal policy mistake (a trade war with China) and a monetary policy miscue (the Fed raising rates too fast) started hitting stocks in late September. These concerned intensified in October when rhetoric from members of the Trump administration grew more aggressive. The S&P 500 responded with its worst month in seven years; and stocks fell 11.5% from the highs reached in September to a low on October 29, and the unease continued into November.

Recent news has been mixed and equity markets have been volatile as a result. In a speech to Congress, Fed Chair Powell hinted at a less aggressive pace of rate increases in 2019, a positive development. Short-term interest rates, however, have risen following the already enacted rate hikes through September and the yield curve has flattened considerably. This threatens to upset credit markets and slow lending activity. On the trade front, President Trump announced a 90-day delay in tariff increases following the G-20 meeting, cooling the escalating trade spat. Equity markets rallied nearly 6% in five trading days to December 1st. Unfortunately, the calm lasted only a single day before a series of tweets from President Trump suggested the “deal” bartered with the Chinese officials wasn’t as positive as had been reported just 24 hours earlier. In response, the S&P 500 had one of its worst days of the year, with a 3% decline on December 4th and an additional 2% decline over the following week. While we began by saying 2018 has been a roller coaster year, that term may be too kind an analogy for markets this year. The tighter financial conditions and trade conflict are causing cracks in the economic outlook. We encourage being patient and avoiding rash decision in investment portfolios, but more caution is warranted today given the increased uncertainty. 

Having weathered all those twists and turns, the S&P 500 has returned 0.5% year-to-date through December 10th. This is well below annual averages, but far from a disaster. Fixed income securities have done their part to reduce volatility in balanced portfolios. However, in a low yield environment, bonds also provided only low single digit returns to portfolios¹. As expected, shorter-term bonds performed better than longer-term ones with rising rates impacting longer duration bond prices more than short. Fortunately, with short-term Treasuries today yielding nearly 3%, there is hope for slightly better returns without bearing undue credit or interest rate risk.

Wish List for 2019

A ‘Normal’ Post Midterm Election Year Rally

When reviewing companies, it is very important to focus on the incentives of management teams. Analyzing politics is similar, and the first incentive for a politician is to get elected. After stumping for his party in midterm elections, a President entering the second half of his term starts to prioritize his next campaign. Strong economies help get incumbents re-elected and policy makers almost always push this agenda. This stimulus has the added benefit of helping propel earnings higher. The ensuing impact on equity performance is consistent. Short-term performance can be mixed, as we have been experiencing recently, but the longer-term experience is impressive (see Figure 1 below). the S&P 500 hasn’t declined in the 12 months following a midterm election in over 70 years! The average annual return in these years is 15%. Past may not be prologue, but we hope history is a guide for 2019.

Trade Dispute, Not a Cold War

Initially, growing trade tensions with China appeared to be about posturing ahead of midterm elections. Things changed for the worse in early October. The Vice President of the United States delivered a strongly worded speech to the Hudson Institute on October 4th, that implied a different level of aggressiveness towards the Chinese. Equity markets fell hard in response over the next month (see Figure 2 below). Instead of a trade dispute, the tone harkened back to the Cold War during which many of us grew up. Investors are willing to pay more for stocks when peace and open trade are the governing norm. Using the pre and post Cold War era earnings multiples as a proxy, this premium is over 30%. The lesson is that when large economic forces can’t coexist in harmony, equity markets suffer. Aside from Mr. Pence’s speech, the messages coming from President Trump and members of his administration have been confusing, as discussed in the preceding section. There is much uncertainty left to overcome, but any progress would be considered positive. Markets are likely able to weather some level of trade dispute, but a new Cold War would suggest additional issues will arise. For the sake of global peace and health of global equity markets, we hope to see a positive shift in Chinese relations. 

An 18th Banner in the Garden

We continue to revel in a World Series victory for our beloved Red Sox so it might be testing fate to ask for more Boston sports success. However, after assembling a roster of talent that rivals the Celtics gloried teams of the past, we are too excited not to ask for an 18th banner to hang from the rafters of the Garden. Our team has yet to find its stride in the early goings of the season, but we hope a little holiday spirit sent from our clients and BFM can get things headed in the right direction.

No Unforced Errors from the Federal Reserve 

The U.S. Federal Reserve (the Fed) is charged by congress to promote the goals of maximum employment and stable prices. To that end, the Fed generally raises interest rates (using the Fed Funds Rate as a primary tool) when unemployment is low, or when inflation is expected to rise too high. Following the financial crisis, the Fed kept interest rates near zero to spur economic growth. In addition, the Fed embarked on additional stimulus efforts using its balance sheet to buy over $4.5T in securities (commonly referred to as “Quantitative Easing”). Rates stayed on the zero bound for seven years and the balance sheet was also maintained. Even though inflation was still very low, when the unemployment rate fell below five percent in 2015, the Fed finally began gradually increasing rates and has continued this path through September. The Fed Funds Rate now sits at a guided range of 2% to 2.25%. The Fed also began reducing the amount of securities held on the balance sheet, putting further pressure on financial conditions. The unemployment rate has declined further (now at 3.7%) and inflation remains subdued at only 1.8%. These tighter financial conditions are starting to have a negative impact on the economy (see housing comments below). Recent comments from Fed governors acknowledge this challenge. There is an old market adage that says bull markets don’t die of old age, they die when the Fed kills them. Today’s backdrop sets us up similarly and we hope policy makers heed mistakes made in the past. We are wishing for 2019 with no monetary policy miscues.   

Stable Housing Market

BFM’s constructive case for equity markets has been predicated on a low risk of recession in the U.S. While the totality of data still supports this thesis, some parts of the economic picture, most notable housing, have become incrementally worse over recent months. Rising mortgage rates have cooled the market with transaction activity and price gains slowly over the last year. Housing is a key element of the economy and has provided the most advanced warning of oncoming economic weakness, (see Figure 3 below). The signal from housing, though, has usually been too early to make rash calls on a recession. New single-family homes sold have peaked on average 31 months prior to the start of the last seven downturns. If last November’s peak proves to be this cycle’s best, history suggests there are still nearly two years left in the current economic cycle and time remaining for this bull market. Resumed stability in this segment of the economy would go a long way toward maintaining the health of the economy and stock market in the new year.

Holiday Cheer

Markets have been difficult the last several months and may leave investors feeling less festive than normal. Instead of focusing on markets, the holidays give us a chance to put things in perspective and enjoy the season. We are hoping everyone can channel his or her inner Buddy the Elf who encourages us, “The best way to spread Christmas Cheer, is singing loud for all to hear.” It is difficult to express warm wishes in a financial newsletter, but we sincerely wish the best for all of you this holiday season. We are very fortunate to have great clients and colleagues and encourage everyone to have safe and happy holidays. 

¹Using the Barclays 1 – 3 year credit total return index as a proxy

Commentary Disclaimer: This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.